This Much-Hated Investment Could Actually Help You

Few investments inspire such devotion and scorn.

Some things, you either love or hate. Annuities definitely fall into that category.

It's surprising just how strongly people feel about annuities. Proponents point to many annuity features that are difficult to find in other investment products. Detractors argue that the price you pay for those features more than offsets the benefits they provide.

Once you cast emotion aside, however, annuities are simply one more tool that you can use to try to create a successful financial plan that will work throughout your lifetime.

Annuity basicsOne source of confusion about annuities stems from how many different types of annuities there are. Here's a short rundown:

Fixed annuities resemble bank CDs and other fixed-income products, in that they earn a guaranteed interest rate for a certain period of time.

Variable annuities look a lot like mutual funds. When you pick a particular variable annuity, your money is invested with other annuity holders in a pool of investments. For instance, Vanguard's Equity Income variable annuity invests in shares of well-known stocks like JPMorgan Chase(NYSE:JPM), Chevron(NYSE:CVX), and Johnson & Johnson(NYSE:JNJ). You can choose variable annuities tied to stocks, bonds, or other niche investments such as real estate investment trusts.

Immediate annuities start paying you a monthly benefit right away after you buy the annuity. All annuities allow you to annuitize your policy and start getting payments, but there are also deferred annuities, which first have a period in which your annuity accumulates value rather than making payments.

Which type of annuity is best suited for you depends on what your particular financial goals are. Fixed annuities sometimes offer higher interest rates than you can get from FDIC-insured bank products. With variable annuities, many companies will let you choose from several optional guarantees that can help protect your assets from market downturns and other unexpected events. Immediate annuities can help you eliminate the risk of outliving your money by passing your longevity risk from yourself to the annuity company.

Moreover, all annuities offer tax deferral. As long as you don't receive payments, you won't be taxed on the buildup in value of your annuity.

Are annuities worth the cost?But at least in some cases, there's a catch. The biggest objection to annuities is the added cost to investors. According to the Insured Retirement Institute, the average fees of variable annuities amounted to 2.40% per year, almost double the 1.22% that the average mutual fund charges. In addition, annuities often come with other strings, such as surrender charges that you'll pay if you withdraw money from your annuity within a certain period of time.

The big question, though, is whether the benefits you get are worth the extra cost. Certainly in the stock market's big downturn, those who opted for annuity guarantees fared far better than most investors, in some cases seeing their annuities rise in value despite the terrible performance of the annuity's underlying portfolio. And even though those guarantees have forced some insurance companies, including Lincoln National(NYSE:LNC) and Hartford Financial Services(NYSE:HIG), to accept TARP money from the federal government, that doesn't change how valuable those guarantees have been.

Of course, years like 2008 are thankfully rare, meaning that you won't need that type of extreme principal protection very often. But the guaranteed lifetime income stream that you can get from annuitized payments reduces risk in a way that's hard to do otherwise. Although you can attempt to duplicate that stream of income by combining bond investments with high-yielding dividend stocks like Altria Group(NYSE:MO) and AT&T(NYSE:T), you retain the risk that a falling stock market or a long lifespan will deplete your funds. With an annuity, however, you can choose payments that will last the rest of your life -- no matter how long that proves to be.

Is it worth it to you?Unfortunately, if you never end up using some of the unique features of annuities, you never get any payoff from those added costs over time. That's why so many people automatically shun annuities as completely useless.

Yet as a part of your overall financial strategy, annuities can make a valuable contribution. You need to understand what you're paying for, but if you actually use the features annuities offer, buying an annuity isn't always just a dumb move.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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